Monday, March 21, 2016

Buyback Performance Demystified

Earlier this month, in my post Stock Buybacks Demystified I attempted to remove some of the mystery surrounding buybacks, showing they are no different from an economic perspective (if you ignore the impact of taxes and the effects of signaling) than dividends. Given the recent outperformance of dividend paying stocks (as defined by those in the S&P 500 Dividend Aristocrat index) vs. stocks engaged in buybacks (as defined by those in the S&P 500 Buyback index) over the last year, I thought it might be helpful to demystify what has driven the recent outperformance of dividend stocks, share the historical performance of each, and outline some forward expectations for relative performance given where we currently sit.

Background: Buybacks have consistently outperformed since inception 

The first chart shows the growth of $1 invested in dividend stocks vs $1 invested in buyback stocks going back to the inception of the S&P 500 buyback index in early 1994. What we see is pretty consistent underperformance of dividend paying stocks over time that has compounded to 2% / year outperformance of the buyback stocks since inception (note both have outperformed the S&P 500). 

Background: Relative performance is highly mean-reverting
The second chart shows the relative performance of dividend stocks less buyback stocks over 12-month rolling periods going back to the inception of the S&P 500 buyback index. What we see is:
  • Pretty consistent underperformance of dividend paying stocks (most of the relative return series is negative) 
  • Mean-reversion characteristics (when one outperforms the other materially, it tends to bounce the other direction pretty quickly)
  • Dividend outperformance during periods of market stress 

Why have dividend stocks outperformed recently? Valuation differences
In addition to market stress that favors dividend stocks, the change in relative valuations have driven dividend stocks (i.e. it's been seemingly more technical than fundamental). The chart below shows valuations (i.e. P/E) of the dividend and buyback indices as of month-end February and as of a year ago. While dividend stocks were richer by this measure even a year ago, valuations among dividend stocks have held up pretty well. On the other hand, valuations among buyback stocks have gotten materially cheaper, driving the relative underperformance of buyback stocks and creating a huge valuation gap between the two. 

What now? 
The final chart shows the impact of shorter-term (12-month) relative performance between dividend and buyback indices on longer (3-year) forward relative performance. We can see:
  • Pretty consistent underperformance of dividend paying stocks over most three year periods 
  • Mean-reversion characteristics kicking in when dividend stocks have outperformed by the 10% level they have over the last 12-months (when dividend stocks have outperformed by 10% or more over a 12-month time frame, they have underperformed by an average of 6.4% / year for the next three years)

Neither dividend stocks or buyback stocks outperform in all periods or market environments, but under the view that the underlying economy appears to be holding up, current valuations, the historical outperformance of buyback stocks, the mean-reversion characteristics of buybacks (following recent dividend outperformance), and certainly the tax efficiency of buybacks all seem to support a tilt toward buybacks.